Thursday, May 20, 2010

If you’re on Team Edward, you might think the fundamental transformation in Twilight: Breaking Dawn is a person getting turned into a vampire. Or if you’re on Team Jacob, you might think it’s a boy morphing into a wolf. But if you’re an economist, it’s the conversion of undifferentiated assets into relationship-specific assets.

That came out more boring than I planned. But it’s true! On Deadline Hollywood, Nikke Finke reports that several supporting actors played hardball during negotiations for the final installments of the Twilight series:

Really, my eyes glazed over at the recent ruckus that those secondary actors were demanding as much as $4 million each to do the 4th and 5th installments of the Twilight Saga. ... I’m all for higher pay for thesps, and Summit has tons of cash to spread around. But in this case Summit gave these actors their big break, and offered them 10 times what they’d made in the first movie, and could have replaced every one of them with hungry unknowns had it not been for the execs’ fears of offending fans.

We’ve seen this happen before, of course, most notably when the six leads on Friends wangled $1 million each per episode in their final season. In economics jargon, stories like these illustrate what Oliver Williamson dubbed the fundamental transformation (see p. 176).When an organization (such as a firm) acquires new assets (such as employees), those assets are typically undifferentiated at the outset. The firm has many other equally suitable options, and thus the potential employees have limited bargaining power. But after they join the organization, they undergo a transformation. They gain value to the organization that they lack outside of it, and thus they’re no longer undifferentiated from all the other options. Now there’s more room for bargaining, and the parties may try to claim a larger share of the gains from continuing the relationship. That’s just what the Twilight supporting actors have done.

What’s less obvious is the symmetry of the situation. The owner of the relationship-specific asset can threaten to hold-up the process, but so can the buyer. Say having the specific actor from previous installments of a series is worth $5 million to the studio. Meanwhile, the actor’s best alternative movie offer is $1 million. Then there’s a $4 million pie to be cut, and an offer of $3 million would exactly split the gains from trade. But the studio may hold-up the process by refusing to pay a dime over $2 million, while the actor may threaten to walk for anything less than $4 million. Both parties stand to lose if they walk away, which is why they usually end up settling somewhere in the middle (often with the final number undisclosed to the public). But every now and then, the deal falls through -- especially when the parties disagree about how valuable that relationship-specific asset really is.

Human assets aren’t the only assets subject to the fundamental transformation. To take another example from the movie business, the selection and creation of sets transforms undifferentiated assets (apartments, furniture, lumber, etc.) into relationship-specific assets. And in some cases -- for instance, a private home rented as a location -- the same problems can arise. But for physical assets, there’s often a simple solution: buy the asset outright. That solution is not available for human assets... although some would argue the old studio system came close.

(For another application of the fundamental transformation, see here. Cross-posted at ThinkMarkets.)

2 comments:

David Friedman has a very nice account, in his Price Theory book, about marriage as a bilateral monopoly with firm specific capital. Although he uses slightly different terminology, he offers an analysis compatible with yours. You cite the old studio system as a possible cure for the high transaction costs you describe, for instance, whereas David cites the marriage contract as a ready fix.